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NOVEMBER 24, 2015  
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Health Care News Network (HCNN), is published on an as-needed basis to keep you informed of current news impacting health care organizations.
 

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Accounting for Leases: Update to Proposed Changes by FASB
 
By: Cory Van Maanen
 
Based on the November 11, 2015 vote conducted by the Financial Accounting Standards Board (FASB), the amended accounting guidance for leases has been approved to be sent to final drafting. The final Accounting Standards Update (ASU) is expected to be issued in early 2016. For public organizations, this standard will be effective for fiscal years (and interim periods within those fiscal years) beginning after December 15, 2018. For private organizations, it will be effective for annual periods beginning after December 15, 2019, with early adoption being permitted upon issuance of the standard.
 
Below are some considerations for both implementation and current decision-making based on what is known and expected today.
 
Basic Provisions
The obvious impact of this standard will be that any lease greater than one year will now be reported on the balance sheet. Each lease will be reported as a right-of-use asset and lease liability, at the present value of future lease payments, utilizing the organization's incremental borrowing rate (private organizations will have the opportunity to elect to utilize the term-appropriate risk-free rate). This has been widely understood and generally accepted for some time. The embattled discussions have centered on the income statement impacts and lessor treatment.
 
After many deliberations and revisions, the proposed changes will result in two lease types: Type A and Type B. Type A leases are those that consume "more than an insignificant" portion of the asset leased, comparable to capital leases under current guidance. Type B leases are those that consume "not more than an insignificant" portion of the asset, comparable to operating leases under current guidance. The lease classification will continue to be centered on existing accounting principles generally accepted in the United States (U.S. GAAP). So, learning those capital lease tests in college or for your CPA exam won't be for naught.
 
Income Statement Approaches - How Can You Plan Ahead?
Type A leases (comparable to capital leases under current guidance) will incur amortization of the right-of-use asset on the straight-line method and interest expense on the lease liability (this interest expense volume will be similar to a mortgage where more of the interest is recorded in the first years and it diminishes over the duration of the lease), in a similar nature to the current capital leases. Expenses will be higher in initial years and decline throughout the term of the lease. If you have entered into operating leases, it will be important to understand these impacts in the first few years of implementing this proposed standard. Otherwise, after implementation, the income statement impact of a lease versus a financing arrangement will be minimal.
 
Type B leases (comparable to operating leases under current guidance) will incur a "single lease expense" comprising interest expense similar to above and amortization on a basis that will result in the single lease expense being straight-line over the term of the lease. In other words, the impacts will be similar to current operating leases, except the right-of-use asset and lease liability will now be recorded and will more closely match the cash payments being made. This is of importance because the process for tracking and recording these leases may need to be a manual process, and asset management systems most likely will not allow an amortization calculation on an "increasing method." In addition, recording of the "single lease expense" will either require a new process or a change in G/L or report mapping.
 
There is also a potentially significant operating impact related to Type B leases. If you finance an asset through the use of traditional means (note payable, commercial loan, bonds, etc.), the income statement impact will be higher expenses early and lower expenses later. However, if you finance through a Type B lease, notwithstanding the consideration of ownership, expenses will be recognized straight-line. Depending on the size of the transaction, this can have serious fiscal year operating results ramifications.
 
Other Considerations
Most health care organizations have existing financing agreements that prohibit, limit, or otherwise monitor the incurrence of additional indebtedness. While "operating leases" generally were not within this scope, any lease agreement may now be considered additional indebtedness. So, will that new copier lease potentially be considered a covenant violation, let alone the CT/PET scanner or medical office building lease?
 
The computation of certain financial covenants may potentially be impacted, as well. Generally, under existing agreements, a Type B lease would qualify as debt for the denominator of the debt service coverage calculation; however, the "single lease expense" would not be added back to Income Available for Debt Service as interest and depreciation/amortization currently are. The same holds true for days cash on hand calculations. How close are you to meeting these covenants, and how close will you be in a couple of years?
 
Therefore, it is recommended that discussions with trustees, banks or other lending institutions begin in order to amend agreements or at least clarify potential impacts. So, for example, if existing leases will be "grandfathered" under existing loan agreements, but new leases will be considered debt, this may impact your short-term and strategic capital acquisition activities. If existing leases may create covenant violations, it may be worth restructuring or refinancing the arrangements.
 
While the specifics of the lease guidance have not been finalized, the aforementioned items are the current details that we have been made aware of and are some of the areas that should be considered now because they will impact you in the future.

For more information on the proposed changes and related impacts, please contact your Eide Bailly representative
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Cory Van Maanen
Audit Manager

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